Pop quiz time. Are you smarter than 70% of Americans when it comes to one major aspect of your life? Answer the following three questions:
1. Suppose you had $100 in a savings account and the interest rate was 2% per year. If the money was left alone and allowed to grow, how much would you have in the account after five years?
a) More than $102, b) exactly $102, or c) less than $102?
2. Imagine that the interest rate on your savings account was 1% per year, and inflation was 2% per year. After one year, you be able to buy:
a) more than today, b) exactly the same amount as today, or c) less than today?
3. Is the following statement true or false?
"Buying a single company's stock usually provides a safer return than a mutual fund."
A surprising number of people around the world get these questions wrong, including those who believe themselves to be financially savvy. (If you're playing along at home, see below for the answers, as well as explanations of these core concepts.)
Annamaria Lusardi is professor of economics and accountancy at The George Washington University School of Business, and is one of the authors of a study published in 2014 that posed the questions above. "These are the principles at the basis of financial decision making," Lusardi said in a phone interview. "They are the ABCs of finance."
Owning up to our financial fogginess. If you feel like you were absent the day your classmates learned their financial ABCs, you're not alone. Another recent study by PwC and the Global Financial Literacy Excellence Center at GWU School of Business found that only 24% of millennials demonstrated understanding of basic financial concepts.
Despite being considered the most educated generation — and consequently saddled with considerable debt — many of us have a lot to learn when it comes to money.
"The real problem is that math skills are taught in high school and many important financial decisions come much later," Richard Thaler, Charles R. Walgreen distinguished service professor of behavioral science and economics at University of Chicago's Booth School of Business, said in a phone interview.
"Just-in-time" financial education. For those of us long out of high school and recently or soon-to-be graduated from college, there's no point in lamenting what we failed to learn back then. We can only look forward and pledge to educate ourselves now.
"We need more 'just-in-time' training," Thaler said. "The best education would come in just before big decisions, such as taking out a student loan or a mortgage."
Whether or not you've got big decisions on the horizon, the road to financial literacy begins right where we started: understanding the Holy Trinity of compound interest, inflation and risk diversification.
Your financial cheat sheet. If you answered the above questions with a, c and false, congratulations — you're in the 30%! If you're in the 70% with the rest of us, don't sweat it. Our primer below will help you lay the foundation for your future financial fitness!
Compound interest is how you can make money grow over time. Say you put $100 in an investment that pays an interest rate of 10% per year. At the end of two years, you have $121, because the interest grows not just on the amount you invested, but also on the interest you've earned. This is why you should start saving money as early as possible.
Inflation measures the change in prices over time. When prices increase, our purchasing power decreases (our money buys fewer goods). Even if we earn interest on our money, if prices grow faster than interest rates, our purchasing power decreases. Keep an eye on inflation!
Risk diversification: if you invested your money in a single company stock, the payoff could be huge — but the chances of losing it all may also be huge. A mutual fund, which invests in a variety of assets, including stocks, bonds and commodities, spreads the risk of loss.
While understanding these simple concepts may help your money go a long way, there are also many small tips you can learn to manage your money better. From apps that can help you keep track of your budget to online banking and sources of financial education, there are ways to learn more about how to manage money even though you're out of school.
There's no time to learn like the present. The longer you wait, the more interest you'll miss out on.